Financial Sector Reform and Economic Growth in Malawi

1. CHAPTER 1: INTRODUCTION

1.1 Background and Review

"Economic growth is a long-run increase in the capacity of the economy to produce goods and services, and can be illustrated by an outward shift in the production possibility frontier."

Riley, 2006

Financial sector reform is a change required to make a financial system more efficient in allocation of an economy's savings and a driving force towards positive economic change and growth. There are two main ways of achieving reform and these include "liberalization" of the financial sector and control of the "private sector" for the sake of "social interest" (Williamson, 1999: paragraph 1). Some researchers argue that financial sector reform can bring about economic growth. Others however disagree saying it may actually have adverse effects and be an impediment to growth by reducing savings (Ziorklu, 2001: 47).

Many economic growth models have been developed by economists over the years, however in relation to financial sector reform the important models are those that directly incorporate savings, interest and investment. The Harrod-Domar growth model, though heavily criticized and considered inapplicable (William, 1997), the Solow's growth model (Colander, 2002) and Joseph Schumpeter's (King and Levine, 1993) economic development theory are therefore imperative in assessing the effects of financial sector reform on growth because they all include and state that savings and investment and hence a strong financial sector is important to drive economic growth.

Financial sector reform can lead to greater availability of credit, higher interest rate and increased savings which can then be channeled towards investments much needed for economic growth. Reform can also lead to more efficient allocation of resources by redirecting lending to more credit worthy borrowers (Williamson, 1999). However, financial reform is not always positive especially in more complex financial systems. Financial instruments can indirectly have a negative impact on investment in an economy through speculation and deregulation of financial activities such as hedging while in some cases in more developed economies they lead to reduction of "precautionary savings" (Ang and McKibbin, 2005: 2).

Reform involves many factors such as liberalization and deregulation of interest and exchange rates, lowering taxes, and privatization of the financial sector. It can however, be a problem in an economy facing macroeconomic instability (Mwega, 2002). This is because to control inflation and unemployment government needs to increase regulation of economic factors much needed for reform such as monetary and fiscal factors.

Malawi is a small economy and undertook financial reform in the late 1980s (Chirwa, 2001). Its financial sector is dominated by banks, which constitute more than 80% of the sector and so financial reform was mainly based on controlling and liberalizing banks (Nissanke and Aryeetey, 1998). The late 1980s, as mentioned above, marked the beginning of its financial sector reform. Malawi's financial reform was based on the IMF financial sector reform program and started off with liberalization of interest rates in 1987. Interest rate deregulation was followed by the formation of capital and money markets and liberalization of the banking sector to increase competition (Mowatt, 2000). Malawi's financial sector reform also entailed reducing government intervention in the financial sector. Chirwa and Mlachila (2004) noted that in essence the financial liberalization process was officially completed in 1994 but further liberalization is still required. Malawi's financial services are still at a basic level and Malawi is still dependent on the informal credit market.

Given the situation in Malawi the main issues and points of interest are: firstly to investigate the role has financial sector reform played in Malawi since 1987, secondly whether there is still a need for change and thirdly what kind of reform is required to help the country establish a financial system that will achieve positive economic growth. A basic economic growth trend analysis from 1980 to 2008 based on GDP can be a starting point to see how growth has changed pre and post reform.

As can be seen in the figure 1 below, before 1987, the pre-financial reform period, GDP at current prices was relatively constant. Then, between 1987 and 1994, during the reform, GDP fluctuated between $2.5 and $1 billion. Finally, after 1994, the post reform period, GDP had a general upward trend. It would be easy to say from this simple analysis that reform has a general positive effect on GDP but the GDP growth trend is a complex combination of factors and cannot be explained by financial sector reform alone. Liberalization is also accompanied by higher prices, thus it is not certain that real GDP grew post-reform by using the trend in figure 1 alone.

Figure 1

GDP trend at current prices in Malawi (1980-2010)

Source: IMF DATA, 2011

To analyze financial sector reform and its effect on economic growth within Malawi a careful analysis of various growth and reform theories and of Malawi's economic indicators and policies is needed. Many complex econometric models based on financial sector performance in relation to various economic factors have been generated for various economies. As found in numerous theories and commonly used in observing any factors relationship with economic growth the usual dependent variable in econometric analysis is GDP. The main indicators when observing the financial sector include inflation, interest